Disclaimer: Any opinions expressed, potshots taken, or scientific views articulated are mine, and need not represent the opinions, potshots, or scientific views of the Federal Reserve Bank of St. Louis, or the Federal Reserve System.

Wednesday, January 25, 2012

The FOMC Sticks Out Its Neck - Again

The FOMC meeting that took place over the last two days was an important one. The first big piece of news is in the FOMC statement in this paragraph:

To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.

The previous statment from December read as follows:

The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

So, policy is now to be more accommodative. Presumably something changed. Somehow the state of the world must look worse in some unexpected way on dimensions the Fed cares about. What could it be? In the first paragraph of the current statement, we learn that the recovery is proceeding, perhaps more slowly than might have been anticipated a year or two ago, but maybe a little more quickly than was expected at the last FOMC meeting. Inflation has decreased slightly, but the Fed had expected that, and the inflation rate is increasing in terms of core measures. So why the policy change? Why indeed?

This is a very risky policy move. By the end of 2014, the interest rate on reserves (IROR) will have been at 0.25% for more than six years. The Fed has never made such a commitment before, and they have no clue what will happen as a result. Here is what could happen. Months from now, a year from now, or whatever, banks may get the idea that bank reserves are a less attractive asset to hold. That would be triggered by better relative returns on alternative assets, which in turn could simply be the result of an ultimately-self-fulfilling higher inflation rate. Banks will start to abandon reserves and prices will rise. What should the Fed do under those circumstances? It should increase the interest rate on reserves to curb the inflation. But it committed today not do that. Everyone understands this, and that's what will get the inflation going. Once higher inflation really becomes entrenched, it's hard to get rid of. How do we get rid of it? Well, we know all about that, as some of us had to live through it in the early 1980s. Time for another recession.

This is a replay of the August 2011 decision, except worse. Recall that Fisher, Kocherlakota, and Plosser were opposed on that round, and note that Lacker dissented this time around. Kocherlakota's argument for dissenting last August was that the policy change was inconsistent with the FOMC's previous behavior, and the same argument applies here. Best guess is that Fisher, Kocherlakota, Plosser, Lacker, and perhaps others, are opposed this time around. That would be a serious disagreement, with some astute economists on the nay side.

The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates.

"Maximum employment" crept into the FOMC's language in recent times, but now they are entering into new territory by taking ownership over long-term interest rates. Here, the first law of central banking comes into play: Don't take responsibility for something you cannot control. A central bank controls an overnight interest rate, and any interest rate - like the interest rate on reserves - that it sets administratively. Sometimes, like now, that amounts to the same thing. Though in pre-Accord times the Fed could successfully peg long-term bond rates, it would be incorrect to say that this can be done under typical conditions. Indeed, under current conditions, though the Fed seems to think that its quantitative easing (QE) operations can move long bond rates, it is fooling itself.

The second piece of important information in this latter statement is:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.

So now we have an explicit statement that the Fed's inflation target is 2%, as measured by the rate of change in the pce deflator (raw). That's not an explicit inflation target, as they make it clear that the dual mandate applies - they will tolerate more inflation if employment is lower than "maximum employment," whatever that is, and vice-versa.

The Fed is now also releasing more information on its forecasts, available here. These seem pretty optimistic on the inflation front. FOMC participants are not only forecasting close-to-zero short-term nominal interest rates for years in the future, they are also forecasting inflation rates well below 2% for three years and more into the future. I would love to see the models (and the add factors) that produce those forecasts.

Here's what we see in the data. The chart shows the pce deflator, the Fed's preferred price level measure, going back to January 2005, as compared to a 2% trend beginning at the same time. In level terms, we are now on the high side by about 2%. You have to be creative about the base period to find a case where the actual pce deflator is below the 2% growth path. Thus, it's hard to say that inflation is too low relative to its 2% target path. Given recent history, and the projection for monetary policy the Fed is going on, how could anyone be predicting inflation rates as low as 1.5% over the next several years? You tell me.

Here is another piece of information that will either make you laugh or cry. The release of information about the Fed's forecast was supposed to give us some inside information on what the Fed is thinking so that we can feel more secure. In Figure 2 of the forecast summary, we see when the FOMC participants predict "policy firming." Six participants seem more-or-less sensible, and are predicting firming in 2012 or 2013. But there are another six who are not predicting firming until 2015 or 2016. Now I'm not feeling more secure. I want to panic, because those people seem to be incompetent.

20 comments:

1) This is a conditional commitment...right? So there is no constraint on the Fed if circumstances change.2) One can argue the Fed does have some control over long(er) rates via the expectations hypothesis; I presume you think the risk premium component of long rates is more important?

1. It would take a lot to get the Fed to move from the "conditional" commitment. For good reason, they want you to trust them. If conditions warrant tightening before the end of 2012, it's a problem either way. (i) They actually tighten, in which case they have violated the promise, and we won't believe them the next time. (ii) They don't tighten, in which case the commitment they made today was the wrong one.

2. Yes, if the Fed makes a surprise announcement that the policy rate will remain low for an extended period of time, a standard expectatations-theory-of-the-term-structure argument says that the nominal long bond rate goes down. Real rates are another story - that's much more complicated.

Actually, after thinking about this some more, take back #2 in my previous comment. You have to worry about the effect of anticipated inflation on the long rates - the Fisher effect. If the Fed extends the zero interest rate period further into the future, there will be higher inflation, and they may have to tighten more in the period beyond the extended period than was the case before. Thus, long rates could rise.

"Six participants seem more-or-less sensible, and are predicting firming in 2012 or 2013. But there are another six who are not predicting firming until 2015 or 2016. Now I'm not feeling more secure. I want to panic, because those people seem to be incompetent. "

Their forecasts of future rates could differ because a) they make the same forecasts, but have different interpretations of optimal policy response to those economic conditions orb) they have different forecasts about future economic conditions which, even with the same policy rule, call for different policy responses.

You seem to interpret the results only in terms of a). I suspect both a) and b) are at work. Indeed, the projected paths of UE and inflation reveal substantial differences in views among FOMC members, so I don't see why you would immediately discount b).

Under (b), there is a possible scenario with European sovereign defaults and financial markets going to hell again. If so, maybe I would like to see a forecast conditional on that happening, and an alternative where it doesn't. You can see where this goes. They show me a bit of information, and it just makes me more puzzled.

I think one can come up with many scenarios where the outlook presented in FOMC forecasts is justified, including those you mention. Given this, labeling people holding these views as "incompetent" seems completely unjustified.

You also raise the issue of the optimal amount of information to be released by central banks. I certainly agree with you that more information is not always better, but this doesn't imply that the amount of information currently released is excessive. Do you have a precise sense of what the optimal amount is? I can see room for more conditional forecasts as you suggest and measures of forecast uncertainty (like at the Riksbank). My (admittedly weak) prior is that the Fed is not yet releasing too much information.

I fail to understand why the trend line starting in 2005 is a relevant gauge for inflation going forward. Perhaps because it is not as is your observation that pce inflation has been a few decimal points above 2% since 2005.

There's an important question here, which is which inflation rate to be worrying about. If it's the actual inflation rate, then over what period are we talking about: a month, a year, 10 years, or what? Or are we worried about anticipated inflation? The problem with the latter is that we cannot observe it. You can tell me it's low, as the Fed is now, but do I believe you? Further, if the Fed says it only cares about anticipated inflation, current inflation becomes a bygone, and the Fed doesn't care about it. It then becomes acceptable that the Fed never actually controls inflation and only makes promises to control it in the future. My picture is about price level targeting, which has some merit. Under a price level target, the history matters.

"if the Fed says it only cares about anticipated inflation, current inflation becomes a bygone, and the Fed doesn't care about it. It then becomes acceptable that the Fed never actually controls inflation and only makes promises to control it in the future. "

Critics of the BoE have argued this is the mistake it is making.

What are your thoughts on the BoC's conclusions from their research on price level targeting?

"The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

So why didn't they put in the part about monetary and credit aggregates? Seems they are being selective. Not that the whole thing makes any sense to me. It's not what I would write down if I were telling the Fed what to do.

" Given the existence of nominal assets and liabilities, unexpected price-level shocks lead to a redistribution of wealth that affects aggregate output through the asymmetric labour supply responses of young and old household"

wouldn't we be better off if the Fed targeted increasing housing prices and reduction of private debt to (let's pick a target) 75% of GDP? After all, it was private debt that caused this Depression and until that debt is cancelled (or effectively cancelled by inflation) we will have no robust recovery, for we have no engine of either demand or growth.

Given that the economy will not recover and become robust until housing prices are restored to 2006 levels and all our excessive private debt is canceled (reducing private debt to 75% GDP), exactly what should the Fed be doing on these two issues (which you never discuss)?